Weekly Pulse: Running Out of Time

The weather around here has been pretty hot lately but it’s been even hotter in Washington, D.C., where Democrats and Republicans have been locked in a pitched battle over the debt ceiling, the credit cap that Congress puts on the national debt. In what is normally a mundane legislative process worthy of C-Span television coverage, the negotiations were held in the theatre of public opinion. Judging by the leakage we had in the equity and commodity markets this week, investors clearly did not like the overhang of uncertainty.

The philosophical and political differences between Democrats and Republicans are so sharp that no long-term agreement on spending and revenues seemed possible but a compromise has been reached just ahead of Tuesday’s deadline. The United States AAA credit rating is pretty much toast since according to Standard & Poor’s there is at least a one-in-two likelihood that they may lower its long-term rating within the next 90 days.

As the debt debate raged last week, economic news was mostly mixed with U.S. new home sales down for a second straight month but consumer confidence surprising to the upside. In the U.S., the tone from the Beige Book was a bit weaker than the June report. The biggest disappointment showed the U.S. economy grew less than forecast in the second quarter after almost stalling at the start of the year. Bonds rallied on the GDP report which dimmed the prospects for faster growth in the rest of 2011. Canada’s economy has also slowed due to fire and weather disruptions in the energy and mining sectors. The Canadian dollar declined against all of its major trading partners as evidence of a general North American slowdown took a toll on the loonie.

Canadian earnings results were mostly mixed this week with strong results from Potash and Barrick somewhat offset by misses at Suncor, Talisman and Imperial Oil. Rising costs are once again weighing on results at the oil majors despite relatively high commodity prices in the quarter.

GDP Sends Another Warning Signal

The Canadian economy fell in May by the most in two years as energy and mining production slowed. GDP fell 0.3% in the month and grew only 2.2% in the past 12 months – the slowest pace since February 2010. The Canadian dollar extended its losses on the weakness. The soft Canadian results and the bleak Q2 U.S. GDP data (1.3% vs. 1.8% expected), suggest the Bank of Canada will now not be in such a hurry to raise rates. The median forecast for the central bank’s key lending rate fell 0.25% for each quarter of 2012 on the GDP news. The forecast is now 1.75% by March and 2.5% by the end of 2012. The current overnight lending rate has been stuck at the ultra low level of 1.0% since September 2010.

The Trading Week Ahead

This is the week when the gloves come off on the U.S. debt ceiling debate. August 2nd is the deadline for a deal since according to the U.S. treasury the government will run out of money on that date unless a deal is struck. We expect a deal will be reached at the eleventh hour and stocks could rally 3 to 5% on the news of a deal early in the week. How long the euphoria lasts is anyone’s guess since the overhang of the U.S. credit rating and Europe’s debt woes will still persist beyond Tuesday’s deadline.

On the economic data front, the Canadian and U.S. July ISM Manufacturing surveys are both key. Following last week’s GDP data, we would expect them to both be in the low 50 zone, a level consistent with more moderate growth. An ISM Non-Manufacturing (Wednesday) level of 53.0 is roughly consistent with about 2.3% real GDP growth over time. By the end of the week, the focus will be on the employment front. We suspect a better payroll reading relative to the extreme weakness of recent months, but not what you would call a ‘strong’ number. We believe last month’s shockingly weak 18K gain understates the reality, and some catch-up (or a revision) is probably in store. In Canada, we expect employment growth, like the Ivey Purchasing Managers Index (PMI) data, to show some modest improvement for July.

On the global front, Italian data will draw some attention this week with the GDP release for the second quarter and the PMI survey for July. Leading indicators have continued to worsen and we expect this trend to continue. In China, the official July PMI is expected to soften to 50-50.4 from 50.9 in June. Central Banks – the European Central Bank (ECB) and the Bank of England meet this week and neither of them is expected to change rates, but the language of ECB President Trichet at the press conference will be key in shaping rate expectations.

Question of the Week

With the debt ceiling negotiations raging, where can I go to wait this out?

If we cannot rely on U.S. government bonds there are a few alternatives to consider. Gold, silver, and commodities are natural stores of value but prices do go up and down with demand and supply so keeping positions small enough for diversification relative to the volatility seems to make the most sense. Foreign debt of unquestionable solvency of countries like Australia, New Zealand, Norway, and Sweden, and currencies like the Swiss Franc and the Yen are go to destinations in times of crisis but they are not bullet proof.

Imagine a U.S. default, where aggregate demand drops across the world because the U.S. Treasuries sitting on the books of banks of other nations are only worth 70% of face value. Deflation would likely drive commodities and alternate reserve currencies lower. High quality equities that pay dividends are attractive but remember stocks are highly sensitive to confidence and trends in aggregate demand. High quality corporate debt with AAA credit ratings may look attractive but the payments system is interconnected and any non-payment by one will disrupt the ability of others to pay. Our point is that there is no one fool-proof place to hide in times of market stress. We contend that a well-diversified portfolio remains our favored approach as part of a prudent asset management strategy. One should avoid changes motivated by fear or panic as they rarely work out the way one would have hoped.